Many investors claim to be long-term investors, yet they panic and sell all their stocks once a market downturn starts. Real long-term investors remain invested through the peaks and troughs, and eventually reap rewards that short-term investors can only dream of.
To see if you're a real long-term investor, you should ask yourself these ten key questions first.
1. Will you need the money within 10 years? If you'll need your cash within the next decade, don't lock it up in stocks. You don't want to take unnecessary losses or prematurely sell promising stocks just because you need to pay your bills, address an emergency, or make a big purchase.
2. Should you put the stocks in a Roth IRA? A Roth IRA is a great place to put stocks which you never plan to sell. When you place stocks in a Roth IRA, you don't need to pay capital gains taxes on the dividends -- as long as you don't withdraw that dividend income before the age of 59 1/2.
3. Are you reinvesting your dividends? Whether you place your stocks in a Roth IRA or a regular brokerage account, it's always a good idea to reinvest your dividends through a DRIP (dividend reinvestment plan). A DRIP automatically buys shares of the stock with the dividend payment without an added commission.
This strategy compounds your gains over the years. It also smooths out your average price with dollar-cost averaging, by buying more shares at lower prices and fewer shares at higher prices.
4. Can you stomach a 50% drop without selling the stock? Long-term investors have to ride out some brutal declines to realize the true growth potential of their investments. In late August and early September of 1998, shares of Amazon plunged about 40% to a split-adjusted price of under $13. Many investors panicked and sold the stock -- which is worth nearly $1,000 today.
5. Do you have enough cash to buy the dips? Responsible long-term investors always keep enough cash on hand to buy more shares of their favorite stocks when they decline, which reduces their average purchase price. It's a tough contrarian move which reflects Warren Buffett's time-tested advice to be "greedy when others are fearful."
6. Are you keeping up with industry trends? Being a long-term investor doesn't mean blindly holding stocks forever. If a major paradigm shift occurs across an industry, you need to stay invested in the winners and consider dumping the losers.
Amazon, for example, is making it hard for many brick-and-mortar retailers to survive in the over-retailed American market. A decade ago, Apple turned the smartphone market upside down with the iPhone, which torpedoed industry heavyweights like BlackBerry and Nokia.
7. Do you read the quarterly reports and listen in on conference calls? If you don't, you'll miss the major challenges that can sink your stock. Long-term investors shouldn't fret over one or two quarterly misses, but if it's an ongoing pattern, it might be time to reevaluate your investing thesis.
8. Do you know when to cut your losses? A decade ago, BlackBerry and Nokia looked like solid long-term investments. But if you didn't cut your losses as they dropped, you would be sitting on some massive losses today. If you did your due diligence (as listed in the previous three points), you would probably have sold them years ago.
9. Does your portfolio include too many cyclical stocks? Investors are sometimes drawn toward cyclical stocks -- like automakers, energy companies, and airlines -- because they look fundamentally cheap. However, these stocks are usually meant to be bought at multi-year lows and sold at multi-year highs.
If you hold them for the long term, they often underperform the market. For example, Chevron rose 26% over the past decade through some very choppy growth, but that compares poorly to the S&P 500's 62% gain. I'm not saying investors should avoid all cyclical stocks, but they shouldn't account for too much of their long-term portfolios.
10. Are you properly diversified? Properly diversifying your portfolio across multiple sectors and asset classes makes market downturns less painful. Every investor defines diversification differently, but I personally keep at least ten stocks in my portfolio with a few bonds on the side.
If too many of your stocks are focused on the same industry, keep the "best in breed" players and sell the others to diversify into other industries. However, never invest in companies you don't understand for the sake of diversification -- always do your homework first.